Visit vanguard.com or contact your broker to obtain a Vanguard ETF or fund prospectus which contains investment objectives, risks, charges, expenses, and other information; read and consider carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss in a declining market.

Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries.

An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.

All investing is subject to risk, including possible loss of principal.

When I was growing up, the shopping authority in my family was Consumer Reports. As we shopped for cars, washing machines, or cassette players with Dolby stereo, we’d wield the magazine like a talisman to protect us from lemons.

If I wanted a tape deck that could eliminate the hiss from my 8-tracks, I shopped among those that had eliminated the hiss in lab tests. Billy Joel never sounded so good.

A crack in the rearview mirror

When I began to shop for mutual funds, I approached the task with the same mind-set. To find funds that would make me rich, I simply had to identify those that would have made me rich in the past. It seemed so easy.

Soon enough, of course, I learned the truth behind the boiler plate: Past performance is no guarantee of future results.

This surprising reality is apparent in the table below, which comes from the Vanguard research paper The case for index-fund investing. Vanguard looked at the 20% of U.S. stock funds—”the top quintile”—that had generated the best returns relative to their benchmark indexes for the 5 years ended December 31, 2007. The researchers then tracked the performance of those same funds over the subsequent 5 years.

Notes: The first two columns rank all active U.S. equity funds within each of the Morningstar style categories based on their excess returns relative to their stated benchmarks during the period cited. The shaded columns show how the funds in each quintile performed over the next five years. Sources: Vanguard and Morningstar, Inc.

If past performance were a reliable guide to the future, you’d expect most top-quintile funds to remain in the top quintile. If it told you nothing, you’d expect the top performers to scatter more or less equally across all five quintiles in the subsequent period.

The second pattern prevailed. In fact, the reality was a bit worse. Only 14.9% of the onetime champs remained top-quintile performers in the subsequent 5-year period; 24% delivered bottom-quintile performance; and 16.8% disappeared, a bad outcome regardless of returns before the funds’ extinction.

Investing truths

Maybe you can’t shop for mutual funds in the same way that you’d buy a toaster. The past nevertheless provides useful insights, though they’re more subtle than simple lists of best and worst performers.

Most important, the relative returns—and risks—of broad asset classes have proven more predictable than the returns of individual funds.

Stocks have offered the highest potential returns, but with the greatest risk of declines.

Bonds have offered more modest potential returns, but more price stability, which can help diversify a portfolio of stocks.

Money market funds and other savings vehicles have offered the lowest potential returns, but the greatest price stability.

We expect these patterns to persist. The most reliable way to capture the characteristics of these asset classes is to diversify broadly across each.

The past also reveals another lesson: If there’s one signal that has been better than others in identifying which funds will outperform the pack, it’s cost.

Whether it’s index funds targeting similar market segments or actively managed strategies with similar strategies and objectives, you can enhance your chance of picking “the winner” by choosing the low-cost option.

Andy Clarke

Andy Clarke helps lead Vanguard's Corporate Communications department.
Before joining Vanguard in 1997, Andy worked at Morningstar as an investment analyst. He is the author of Wealth of Experience, an introduction to investing based on ordinary people's stories about what has—and hasn't—worked as they've tried to meet their investment goals.
Andy holds a B.A. in English from Haverford College and is a CFA charterholder.

Comments

Paul D. | November 27, 2013 12:06 pm

Well done Andy.
Clarifying cost as the one attribute to investing that has the greatest impact on outcome. It’s the same as the old Consumer Reports “Best Deal” category…thereby getting more for your money…except that you had to take their word for what a ‘Best Deal” was.

With investing it’s more simple, the more you pay for any return, the less of that return you have left. The less you pay for any return, the more of that return you have left. Some say that ‘Cash is King’ but I prefer ‘Cost is the Kingmaker’.

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Visit vanguard.com or contact your broker to obtain a Vanguard ETF or fund prospectus which contains investment objectives, risks, charges, expenses, and other information; read and consider carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss in a declining market.

Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries.

An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.

All investing is subject to risk, including possible loss of principal.